A boom based on little more than a bezzle

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When the future arrived in 2007, we learnt that others had febezzled from us on a massive scale. And that we had also febezzled from ourselves.

The “bezzle” is one of John Kenneth Galbraith’s best inventions. There is an interval during which an embezzler benefits from stolen money but the victim does not know he has lost it. The bezzle is the amount by which the world is better off in the meantime. Bernard Madoff created the largest bezzle in history.

Charlie Munger, Warren Buffett’s long-term business partner, described the “febezzle”. Mr Munger doesn’t have the gift for language of Galbraith, and I doubt the febezzle – the functionally equivalent bezzle – will catch on. The febezzler benefits from legally appropriated money but the victim does not yet know that he will have to pay for it. In the last decade we have all been victims of febezzlement on a scale that consigns Mr Madoff to the little leagues.

Almost every profitable commercial activity takes time. Many commercial contracts – a construction project, or a supply agreement – run for several years. Most financial transactions, such as loans or investments, take time to evolve. But profits are reported annually, or even more frequently. How should the profit be allocated over the life of the contract?

In a world of perfect certainty and transparency the answer would not matter very much. Every project would yield a known and predictable cash flow. Analysts, investors and creditors could then make the various assessments that suited their different purposes. So could remuneration committees. But absence of certainty and lack of transparency create the scope for febezzlement.

There is no right or wrong answer to the question of how profit should be distributed over time. The straight-laced founders of the accounting profession believed that only birds in the hand counted. They recognised cash only when it was received, or at least legally committed to be paid. They took a prudent view of future liabilities. The profits they recorded arose at the end of the activity that gave rise to them. They dealt with uncertainty by acknowledging only what was certain.

Modern accountants, however, have been taught modern finance theory in which markets are efficient. They handle uncertainty by assuming that the market has already discovered and assessed all relevant information. They have also been taught the skills of pleasing clients. Such accountants mark assets and liabilities to market. Rigorously applied, mark-to-market accounting means you must constantly re-estimate the potential profit from an activity through the course of its life. You are entitled to credit yourself with the anticipated profit on an activity as soon as you begin to engage in it.

If a question has no right answer in principle, then people will argue for the answer they want in practice. Financial markets want steady growth in reported earnings and that is what finance officers gave them. Fannie Mae was particularly proud of its record. Mr Madoff also boasted of the low volatility of his returns. The surest way to report stable profits is to make the numbers up.

But bonuses are paid not for predictable returns, but for large returns. In the creative hands of a man like Enron’s Jeff Skilling, mark- to-market accounting means you can clock up the profit from a good idea as soon as you think of it. In theory, this treatment has justification, but the scope for abuse is obvious.

If this is not enough, you can accelerate profits by marking to market and defer losses by reference to fundamental value. Even if your accountants are not obliging, you may be able to recognise profits and ignore losses by trading profitable assets and holding unprofitable ones. Extreme asset price volatility and wide valuation errors extend the range of manipulation still further.

That is how we came to experience a decade of gross febezzlement. Bankers floated businesses that would never generate any cash, traders exchanged debt securities at inflated prices, consumers took out loans they couldn’t afford. The consumers, at least, understood the essential nature of febezzlement: febezzlers borrow from the future with no intention to repay. When the future arrived in 2007, we learnt that others had febezzled from us on a massive scale. And that we had also febezzled from ourselves.

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